Why The Chinese Economy Could Already Be Larger Than America's

Michael
Pettis is a professor at Peking University’s Guanghua
School of Management, where he specializes in Chinese
financial markets, and a Senior Associate at the Carnegie
Endowment for International Peace.

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Most of this week’s newsletter was about the release last week of
China’s fourth quarter GDP growth numbers by the National Bureau
of Statistics (NBS). You can find the full NBS report
on their
website, but here is the key paragraph:

According to preliminary estimation, the gross domestic
product (GDP) for the year 2010 was 39,798.3 billion yuan, up by
10.3 percent at comparable prices, or 1.1 percentage points
higher than that in the previous year. In terms of growth by
quarters, it was up 11.9 percent for the first quarter, 10.3
percent growth for the second quarter, 9.6 percent for the third
quarter and 9.8 percent for the last quarter.

This places China’s official GDP for 2010 at a nice, round $6.0
trillion. There is of course a lot more interesting stuff
in the NBS report. Those who are worried about excess
investment will find it hard to see the data as anything other
than worrying. Investment has gone up 23.8% from last
year’s already sky-high numbers, and even the best consumption
numbers merely reinforce the sense that there has been no
rebalancing – three of the four consumption items that registered
the most rapid growth were actually investment related.

All this investment-driven growth seems to have come as a
surprise to many people and caused the markets in China and
around the world to drop. I think the markets are right to
be very nervous. The latest growth numbers are likely to
cause real concern in policymaking circles and lead Beijing to do
something to slow it down. Do what? Raise interest
rates, I hope, and that is what I think the markets are most
afraid of.

There were also rumors that the PBoC is going to cut the 2011
loan quota by 10% from the 2010 quota. I don’t believe
it. Or rather I believe the PBoC will try to
constrain monetary and credit growth, because they are genuinely
worried about more misallocated investment and the threat to bank
balance sheets, but this is really not something that the PBoC
can decide. The growth in credit will be whatever it needs
to be to achieve the GDP growth rates the State Council has
decided upon.

To move on to another subject, one of the most entertaining parts
of observing China’s economy is to watch the frantic race between
various Wall Street houses (and a few other players) to predict
the earliest date by which China’s economy will surpass that of
the US to become the world’s largest. This of course is
part of the standard Wall Street hype that accompanies any hot
market. I think that so far the winner (I forget who) came
in with a prediction of 2017.

But last week in a report a new entrant trumped everyone,
although maybe by fudging a little. This new entrant claims
that China’s GDP is already bigger than that of the US,
according to PPP measures.

Perhaps that’s unfair because everyone else is using market
exchange rates, and the poorer a country, the higher the PPP
adjustment tends to be, but it certainly upped the ante. If
any bank researcher wants to beat him, he is going to have to
argue that China’s economy surpassed the US before 2010.

Here is what the author of the report, Arvind Subramanian at the
Peterson Institute, says on the institute’s website:

Cross-country comparisons of economic size and standards of
living of the average citizen rely on two approaches. The first
uses market exchange rates to convert the economic value of goods
and services produced around the world into a common currency,
usually the dollar. According to the IMF’s latest estimates for
2010, the value of total US GDP was $14.6 trillion while that of
China was $5.7 trillion.

…My calculations (explained in greater detail below) based on
the most recent version, which is due in early February, show
that the size of the Chinese economy in 2010 was about $14.8
trillion dollars—surpassing that of the United States.

So there you have it. China’s economy is already bigger
than the US economy according to PPP. I am not disputing
Subramanian’s numbers, but comparisons between two such disparate
economies on a PPP basis of course have no meaningful content at
all. The fact that it is much cheaper to get a haircut or
massage in China (something the latter of which I am happy to
exploit voraciously) tells us very little about the two countries
that we wouldn’t have already known.

Still, it’s exciting, and guaranteed to generate headlines.
Last year we had one “sorpasso”, that of China overtaking Japan
according to market exchange rates, and this year we have
another, that of China overtaking the US according to PPP rates.

But excitement aside, this whole exercise is pretty meaningless,
and not only for the reason you might think – that economic
growth is not a horse race between countries. It is
meaningless for a far more fundamental reason, and this is
because the comparable official GDP numbers for China (and PPP
numbers start with the official numbers and then adjust for local
prices) are wrong.

GDP may be higher

I am not just saying this because, according
to Wikileaks, Li Keqiang doesn’t take the official GDP numbers
too seriously. This was widely reported, but isn’t really
news. None of us take the official GDP numbers too
seriously, especially since it is almost impossible to produce
good data in a large economy that is transforming itself so
rapidly. I am saying that the GDP numbers are wrong for a
more fundamental reason.

GDP is supposed to measure the total value of goods and services
produced in China, but there are several problems with the
official numbers. There are problems with all GDP numbers,
but the biases, especially in the developed countries, are fairly
consistent, which makes cross-country comparisons more or less
meaningful. But in China there are additional problems,
which make cross-country comparisons very complicated.

First of all we know that a lot of Chinese income – more than in
most other major countries – is hidden, for whatever reasons, and
this tends to pull down reported GDP numbers. One plausible
recent estimate is that roughly 10% of total income is hidden
beyond the NBS surveys, and so this suggests that GDP might
really be substantially higher.

I wrote about this in my blog in my August 8
entry. I have no idea if this 10% number is correct or
not – the NBS insists that their surveys are more accurate – but
clearly there is room for a lot of fudging, and the amount of the
fudge can be significant.

Second, when you compare the US and China (or any two countries),
you have to think carefully about the exchange rate you’re
using. The standard method is to use the current market
exchange rate, not because it is the conceptually correct
exchange rate, but rather because it is broadly meaningful when
you think about international trade and, more than anything else,
it is objective. At any point in time I can convert any
Chinese GDP number into its incredibly precise dollar equivalent.

But what if you believe that the RMB is undervalued by 20% and
held there only because of PBoC intervention? Doesn’t that
mean that if the PBoC were to stop intervening China’s GDP would
automatically be 20% larger relative to the US?

Yes, it should be larger, but not by 20%. The difference
should be less than 20%, but how much less depends on how much of
China’s GDP growth can be explained by the undervalued currency.

If part of the country’s high growth rate is a consequence of the
undervalued exchange rate, and certainly Beijing seems to believe
it is, than raising the value of the RMB would automatically
cause a slowdown in Chinese growth. That is why analysts
should consider the relationship between the two when they make
projections, and by the way they are implicitly (if not very
accurately) doing so when they calculate PPP numbers.

GDP may also be lower

But there is more. So far nearly all the adjustments and
predictions about Chinese growth that we have seen in the press
suggest that the “real” size of China’s economy requires upward
revisions of official GDP numbers, but that might reflect China
hype more than a judicious approach might justify. What if
China’s GDP numbers seriously overstate the true value of China’s
economy?

There are at least two very good reasons to believe that they
might. The first is environmental degradation. To
understand why, it is worth remembering that if an individual
earns $100, but in so doing destroys $100 worth of his own
assets, then a strict accounting would say that he earned
nothing.

The same is true with the environment, which has a real economic
value that can be adversely affected by certain kinds of economic
activity. For example here is an
article that came out four months ago on Bloomberg:

China, the world’s worst polluter, needs to spend at least 2
percent of gross domestic product a year — 680 billion
yuan at 2009 figures — to clean up 30 years of industrial waste,
said He Ping, chairman of the Washington-based International Fund
for China’s Environment. Mun Sing Ho, a senior economist at Dale
W. Jorgenson Associates and a visiting scholar at Harvard
University in Cambridge, Massachusetts, put the range at 2
percent to 4 percent of GDP.

Failure to spend that much — equivalent to the annual GDP of
Vietnam — may cost the Chinese economy half as much again in
blighted crops, health costs and pollution-related expenses, He
said: “The cleanup can’t catch up with the speed of pollution” if
spending is less.

This article suggests that a significant portion of Chinese
growth came with a destruction of value that should have been
deducted from that growth. After all, if you create net
$100 of chemicals, but in so doing you pollute a nearby river to
the extent that future economic production associated with the
river is reduced by $100 (there will be less fishing, perhaps, or
less agricultural production, or less usable water, or more
health care costs), then the net value you created is 0, not
$100, although of course you as the polluter might earn $100
today while the rest of the country loses $100 over the future.

There is no objective way to figure out how much of Chinese GDP
growth should be reversed because of environmental degradation
(and in this China is simply an extreme case – most countries to
a lesser extent have this problem), but there is no question that
the number is big, and the result is that we overestimate China’s
GDP growth today and will underestimate GDP growth
tomorrow. In other words environmental degradation simply
causes us to take future growth and count it today.

And it is not just environmental degradation that may require a
downward adjustment in GDP. What about misallocated
investment? Doesn’t that do the same thing?

Of course it does. If you invest $100 today to create only
$80 dollars of value, you will show an increase in today’s GDP
that is lower than the reduction in tomorrow’s GDP as you pay the
capital cost of the investment. In that case if you really
wanted GDP to account for changes in a country’s wealth, your
investment should have shown up as an actual reduction in today’s
GDP. This means, once again, that you would overstate
growth today and understate it tomorrow.

Every country wastes investment, but China does it on a massive
scale. I would argue that at least 1-2 percentage points of
Chinese growth, perhaps even more, might consist of this kind of
misallocated investment-driven growth.

When you add the impact of misallocated investment and
environmental degradation, the necessary cumulative adjustment to
Chinese GDP might be huge. For example, if the two
adjustments combined range from 2 to 4 percentage points
annually, over one decade China’s “true” GDP (whatever that
means), would be below the official numbers by anywhere from
16-31%. Over twenty years official GDP would be overstated
by 31-52%. That means that we are massively overstating GDP
today and will experience very low apparent GDP growth
for many years in the future as the official number returns to
some reasonable approximation of the real number.

These are big adjustments, both above and below the official GDP
numbers. This is why I find the whole horserace to predict
the earliest date by which China’s economy will overtake the US
to be so silly. What we are in effect doing is predicting
the date by which an economy that is officially $6 trillion, but
in reality anywhere from $3 trillion to $15 trillion in size,
will overtake another economy that is roughly around $15 trillion
in size.

And this is not the first time we have played this game.
Look at Japan. Fifteen to twenty years ago Japan’s
GDP was officially 17-18% of the world’s GDP and it was rapidly
catching up to the US. Today it is 8%, and there seems to
be no chance of it every catching up.

But can this really be true? Or is it possible that Japan’s
official GDP growth was vastly inflated by misallocated
investment before 1990, and vastly deflated by the repayment of
that investment after 1990?

I think it’s the latter. If you look at the growth in
Japan’s household consumption, you will find that household
consumption grew much more slowly than GDP before 1990, and much
more quickly after 1990. Household consumption might be at
least as good an indicator of the real growth in wealth as
production-side GDP numbers. So might it not be true that
Japan’s official GDP was too high before 1990, and it has been
slowly adjusting since then? And if this could have
happened in Japan, whose investment growth was high but way below
China’s, why can’t it happen here?

Under these conditions what’s the point of predicting when
China’s economy will officially overtake the US? We simply
have no idea, and we cannot draw any conclusions from the
numbers. Can the horserace generate headlines?
Yes. Can it generate understanding? Not much.